There are no controls on foreign ownership or occupation of UK real estate. As a result the UK market continues to benefit from large amounts of overseas investment, attracted by its settled legal and planning system and prospects for capital and rental growth.
In this note we comment on various issues which an investor will need to consider and address when considering investment into UK real estate.
This note comments solely on English law, covering properties in England and Wales. Although many of our observations apply to both commercial and residential property we have focussed in particular on the commercial property regime.
Investors should consider various matters including funding, taxation, management, and the ability for new investors to join or exit when deciding on a suitable investment structure. Common ownership models include limited liability companies, property unit trusts, real estate investment trusts, limited liability partnerships, contractual joint ventures and ownership under a trust arrangement. Dentons is a full service law firm and we have the ability to advise separately on all aspects of acquisition structuring, tax implications and funding requirements should any assistance be required in those areas.
Real estate in England and Wales is held either by outright (freehold) ownership or for a fixed number of years (leasehold), typically for ninety-nine years or more to ensure the leasehold asset has a capital value. Unlike many other jurisdictions a leaseholder in England and Wales holds an interest in land (as with freehold ownership) as opposed to enjoying merely a contractual right to occupy the relevant property. A leaseholder can usually transfer, mortgage or sub-let its leasehold interest to third parties subject to any pre-conditions or restrictions in the lease. The principal difference between a freehold asset and a leasehold one is that at the end of the leasehold term, the leaseholder will generally need to pay a further capital sum to extend or renew the lease.
The lease will include an annual rent payment obligation however the amount should be nominal where the lease has a capital value because the leaseholder will have paid a premium on the grant of the lease.
Title due diligence
Before its acquisition the buyer will review the seller’s title to the property. The buyer should submit a series of standard property searches (including enquiries of the relevant local authority) and commission suitable professional reports including a building survey. Most real estate in England and Wales is now centrally registered at the Land Registry and so the buyer’s title due diligence will include a review of the Land Registry filed details. Where the property is unregistered land the seller’s title will be demonstrated by the possession of title deeds which should show ownership over a specified number of years. Where we refer to property in this note we have however assumed the land is registered.
The Land Register will provide the following:
- confirmation of the registered owner
- confirmation of whether the property is a freehold or leasehold title
- confirmation of whether the registered owner has a clear unfettered title (title absolute) or a lesser class of ownership (possessory title) where the owner has been unable to show outright ownership
- details of any third party rights, encumbrances or any covenants that benefit or burden the property
- details of any charges or third party notices or restrictions that affect the property
For registered property the Land Registry will need to record any ownership changes, mortgages or leases that affect it. Anyone who suffers loss because of an error or omission in the Land Register, or because the Land Register needs amending, will normally be compensated.
The buyer should ensure that the title does not disclose any covenants that restrict use of the property to a particular class that could potentially restrict the buyer’s intended future use of the asset. For instance a covenant forbidding hotel use, or a covenant restricting use to a residential purpose and not for any business purpose, would have severe implications for a proposed hotel investment or development.
Although the Land Register will include a plan of the property it does not guarantee the accuracy of the boundary outlines. A physical inspection and site walkover should therefore form part of the due diligence exercise. The site inspection may disclose additional third parties in occupation (with or without consent), evidence of any third party equipment on site and any site boundary discrepancies. Under English law third party rights over land can arise over time because of long standing and uninterrupted use. The site inspection should therefore also disclose any signs of additional rights being exercised that are not recorded on the Land Register, for instance where the property is used to access other land.
Real estate leases
With a leasehold property the buyer will need to review the lease to ensure that it does not contain onerous or unduly restrictive user provisions. The lease will confirm one or more permitted uses for the premises (often by reference to named use classes under the UK planning regime) and will also forbid the tenant from using the premises in breach of planning legislation.
For an investment property the buyer will need to analyse the rental streams and the financial standing of the tenants and any guarantors. The buyer will need to review the occupational leases within the property focussing in particular on any early termination rights for a tenant and the rental provisions including the frequency and manner in which any rent reviews are to occur. English law does not impose any compulsory lease terms however the investment market has developed an institutional form of lease which favours the landlord and provides for a lease term typically ranging between five and ten years. We have commented below on certain key provisions from an investment perspective.
Commercial leases usually provide for an upwards only rent review every five years. The reviewed rent will be the anticipated open market amount, based on a series of assumptions and disregards, or will stay at the same pre-review level if the open market amount would not be higher. If the parties cannot agree the reviewed amount the lease should provide for a dispute resolution process. Certain leases may instead provide for a rent review by reference to inflation-based indexation increases or, for retail leases, by reference to a fixed percentage of the tenant’s annual turnover.
Most leases will include a right for the landlord to forfeit the lease and take back the property if the tenant fails to comply with its rental obligations or other lease terms. An open market (or ‘rack rent’) lease is also likely to include an additional right of forfeiture if the tenant becomes insolvent. Forfeiture on insolvency provisions are generally not acceptable to institutional lenders who expect to be able to keep control of the secured asset in an enforcement irrespective of whether they have appointed a receiver over the leasehold interest. If the landlord attempts forfeiture the tenant or other affected third party has the ability to apply to the Court to keep the lease in place. Although the Court has discretion on the matter it will usually grant relief provided the default is remedied.
A tenant of business premises benefits from security of tenure, which entitles it to remain in occupation on the contractual expiry of the lease and to call for a new lease on substantially the same terms at a market rent. Under these circumstances a landlord wishing to recover possession will need to show one of the statutory grounds for recovery (which include a proposal to redevelop). The parties can agree on the grant of the lease to expressly exclude the tenant’s right to security of tenure.
Typically a short term market rent lease will include greater control for the landlord over the tenant’s ability to assign or underlet the lease, whereas a long leasehold interest is likely to be much less restrictive. For more recent leases an outgoing tenant who needs the landlord’s consent to assign may have to guarantee the incoming tenant’s lease compliance as a condition of the landlord’s consent.
Responsibility for repair and insurance under the lease will generally depend on the lease demise. For a lease of the entire building the tenant will usually be responsible for the repair of both the interior and exterior of the building and, similarly, to insure the property. For a lease of part only of the building the tenant will typically only be responsible for the interior. The landlord would then be responsible for the exterior and common parts and services, recovering some of the costs incurred from each tenant under a communal service charge regime. The buyer should review the service charge provisions to ensure there is no scope for any shortfall in costs recovery (for instance if certain tenants only pay a capped amount).
With good planning overseas investors can enjoy considerable tax advantages over UK domestic investors when investing in UK real estate. Stamp Duty Land Tax (SDLT) will be payable by the buyer on acquiring the property and as a result of government changes in the March 2016 budget the SDLT regime for commercial property has been brought into line with the residential system. The purchase price is broken down into individual portions and SDLT is paid at different increasing rates within each particular band. So for commercial property the buyer will pay SDLT on the amount of the purchase price above the first £250,000 at a rate of 5% (a rate of 2% applies for the amount of the purchase price that exceeds £150,000 up to £250,000). Different rate bands apply for residential property and additionally for residential property that is being acquired by a corporate entity. If the buyer acquires the landowning entity as opposed to the land interest no SDLT will be payable and instead stamp duty is payable at the rate of 0.5% of the purchase price. The buyer will also need to pay VAT on acquiring commercial or mixed-use property if the seller has ‘opted to tax’. The buyer can however mitigate against this VAT liability by filing its own option to tax before completion so the transaction becomes a transaction of a going concern.
Income gained from the property will be subject to income or corporation tax at the basic rate of 20% (although the rate for corporation tax will be reducing over the next four years down to 17% from 1 April 2016). This tax is subject to a withholding regime under which the paying entity must deduct the tax due at source and account for it direct to HM Revenue & Customs. Usually however the landowning entity will register under the HMRC ‘Non-Resident Landlord Scheme’. Registration entitles the landlord to receive the rental income gross so it can then deduct expenses (which can include interest charges on borrowing) and file its own UK tax return in the usual manner. The property owner may also need to pay business rates on commercial premises based on their notional value, however if another party occupies the premises the occupier then inherits this liability.
Generally the most tax efficient structure will separate the taxable and non taxable (or trading and non-trading) elements. Typically one entity (for instance an offshore company) holds the property and a separate entity (which can be an English company) manages the operational aspects. Using an offshore company to hold and manage commercial property as an investment (and not trading stock) allows an overseas investor to avoid liability to pay capital gains tax on a disposal.
A prudent buyer should check the property complies with UK statutory requirements on health and safety, disability provision, fire risk prevention and control of regulated materials such as asbestos.
Similarly a buyer will need to be aware of the environmental regime for UK real estate. The contaminated land regime has evolved to help identify contaminated land and include measures for suitable remediation, irrespective of whether the property will be developed. Where the buyer is concerned about contamination risk, whether on-site or off-site risk to a neighbouring property, the transaction documen-tation will need to clarify who is responsible for any clean up costs and any future liabilities.
In response to recent EU legislation the UK has introduced the Carbon Reduction Commitment Energy Efficiency Scheme (CRC) which provides for a mandatory carbon emissions trading scheme to improve the energy efficiency of existing and new buildings. Participation in the scheme depends on the participant’s energy consumption over the qualifying year. Participants must buy allowances from the Environment Agency to regulate the carbon dioxide emissions from their electricity and heating fuel consumption. Landlords may need to purchase allowances covering energy consumption by their tenants and the lease will determine whether these costs are recoverable. The government has however recently announced plans to abolish the CRC from the end of the 2018-19 compliance year and intends to consult later in 2016 on a simplified energy and carbon reporting framework for introduction by April 2019.
As part of the sale of most types of building the seller must provide an Energy Performance Certificate displaying the energy efficiency of a building. From April 2018 buildings with an energy efficiency rating of F or G (currently the lowest rating) are likely to be subject to restrictions on new lettings until they implement certain energy efficiency measures. By 2023 these restrictions are expected to have been extended to cover both new and existing lettings.
Before the property acquisition, the buyer will need to review the planning history to identify any material planning matters regulating the use of the property. Most types of development on land in England and Wales require planning permission. Where there is a failure to gain planning permission, or to comply with a planning condition, the local authority can issue an enforcement notice. An enforcement notice will require reinstatement of the property or compliance with the outstanding planning condition. The planning authority has discretion on the matter and will consider whether enforcement action is expedient and proportionate. An enforcement notice does not itself stop the planning breach and if the planning authority requires urgent action it can serve a stop notice for an immediate cessation. Failure to comply with an enforcement or stop notice is a criminal offence punishable by a fine depending on the severity of the breach. Planning legislation imposes extra controls for buildings which are listed as having special architectural or historic interest.
Where the property includes recently completed development works the buyer will also need to consider the project documents. In particular the buyer will expect to benefit from a series of collateral warranties from the key professional team members including the main contractor. A collateral warranty will create a direct contractual link between the buyer and the key professional. If any problems later arise with the completed development the buyer can require the warranting party to repair the matter either by carrying out further works or by submitting a professional indemnity insurance claim.
The building regulations regime applies to most building works in England and Wales and ensures the health and safety of people in and around buildings. Local authorities must ensure compliance with the regulations and can apply for an injunction or serve an enforcement notice requiring the cessation, removal or alteration of works that do not comply. More serious offences can also lead to prosecution and a fine. The buyer should inspect the building regulations completion certificate as this will show that the local authority is satisfied with the finished scheme.